Don’t Bet on Brexit – or Other Binary Outcomes

Inflation, for example, would be a dynamic risk – it could be higher in the future, but when this might come about, how high it might rise or for how long it might persist are all hard factors to quantify. In contrast to Brexit, inflation is a dynamic risk which is constantly changing, whereas the risk of Brexit remains fixed, even if the probabilities of it happening may rise and fall.

This has important implications for us as investors. If you believe that markets are generally efficient, then you look to see where you might have an information advantage when investing; in other words, what do I know about asset class X,Y and Z which the next investor might not know.

There are three main problem with binary outcomes: they offer little information advantage for investors to play; they are inherently hard to predict; and finally, they offer few easily identifiable markets which might benefit from a particular outcome.

So while we will take the risk of Brexit into account when investing, we explicitly avoid basing specific positions around it, in contrast to how we might look at a dynamic risk like inflation. 

Seeking ‘Information Advantage’

Let’s begin by looking at the first of these three problems, that of low information advantage. By its very nature, a referendum can pose a clear and obvious risk to investors, so information on it is likely to be highly sought after. Research, in the form of opinion polls, is almost constantly being conducted , distributed and updated – as we have seen over the last week.

Polling companies effectively run political polls as loss leaders – they serve as marketing for rest of thier business. These are picked up extensively by broadcasters and the media, hungry for information. So the very dynamics of a referendum campaign mean you are unlikely to ever gain any information advantage. If you do believe you have an advantage, this is more likely to be the result of a gut feeling rather than knowing something which others don’t.

How Accurate is Polling Data?

Even if you do manage to gain some kind of information advantage through polling, you’re then relying on it to be correct – something far from certain. Historically, there’s often a shift in favour of the status quo in the weeks immediately before a referendum (as we saw in Scotland, for example). So if the polls tell you the race is close one month before the vote, should you discount this in anticipation of a shift to the status quo? Or do you take a view that your polling accurately reflects the popular mood?

The list of interpretative decisions goes further still. Telephone polls, for example, have shown a consistent bias to the Remain campaign over online polls - with some arguing that they are more representative and do a better job of reaching people likely to vote Remain.

This view is also supported by The British Election Survey, a telephone poll conducted after the 2015 UK General Election. Importantly, each questioner was instructed to continuously phone the same person to get a response, and the harder they were to reach, the more likely they were to display the kind of biases that were indicative of a vote to stay in the EU.

All this is before we have even considered turnout predictions, or even predictions on turnout by age, with the elderly tending to be more eurosceptic than the young.

Spotting Winners is Harder Than You Think

By this point, I’m hoping I’ve convinced readers not to bet on the referendum in their investment portfolios at all, but I still have one final closing argument – the problem of what you place your bet on at all.

Assume you want to bet on the UK voting to stay in the European Union and buy the FTSE 100 in the expectation of a relief rally. With its significant international earnings exposure, does the FTSE 100 really offer a play on the UK economy, or is it better to seen as a play on the global economy?

Furthermore, a weaker sterling has helped to boost the value of overseas earnings for UK corporates, who report profits in sterling. As such, your bet on ‘Remain’ might only really benefit from a ‘Leave’ vote and further sterling depreciation.  Even the more domestically focused FTSE 250 might struggle after a Remain vote, with it being unclear how much of the recent slowdown in the UK economy is down to Brexit uncertainty, or how much it represents something more fundamental.

Stick to Core Fundamental for Long-Term Advantage

Clearly, news flow around referenda and other binary political outcomes is something we need to follow and take into account when investing across markets and countries.

However, I think there’s a strong distinction to be made between taking ‘political risk’ into account, and actually betting on that outcome.

As portfolio managers, we can best add value by focusing on the output of our fundamental research and processes, rather than looking at information which is widely available and which will be quickly priced in by markets.

Political outcomes can be inherently hard to predict in any case, and it is far better to focus on information which we have scrutinised to ensure it provides insight into the future direction of markets over time, rather than areas where prediction is hard and you need to tackle different interpretations of the same data.

While we can see how various political outcomes might impact markets, it makes more sense to position around asset classes where we can take into account the full picture – on fundamentals, sentiment and technical – rather than trying to disentangle the impact a political result might have on this or that particular market. So by all means have a flutter on the UK referendum, but we’ll use our investment expertise to position funds for the long-term, where we feel we really can add value.

Disclaimer
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